Insights

Dividend Stocks – Getting Pricey?

The quest for yield has elevated the share prices of many large, dividend-paying US stocks relative to the rest of the market. Look no further than the S&P Dividend Aristocrat index that has outperformed the broader S&P by a considerable 10% year-to-date. Should the mere presence of a large or growing dividend be a determining factor in choosing stocks or funds? History says no but today’s investors say yes. The reach for yield is understandable – baby boomers entering retirement have a hole to fill. In the long run, however, investor satisfaction will be determined by total return, including capital appreciation or depreciation. The current valuations of many dividend darlings should give discerning investors pause.

While dividend stocks have moved in and out of favor many times, the current chase for yield is unprecedented and years in the making. How did we get here?
• By maintaining interest rates near zero for far longer than expected, the Fed has pushed investors out of CD’s and low-yielding bonds into higher-yielding, riskier assets.
• Some investing “experts” have promoted dividend stocks as a solution to the low-yield challenge and touted their “safety.”
• Wall Street has created convenient vehicles for easy access to popular trades.
• Rising prices add credibility. The cautious are reassured that a “golden age” for dividend stocks is upon us.

Investing theory says we should be indifferent as to whether we receive a dividend or periodically sell a sliver of our holdings as a substitute. In the real world, many investors see things differently. Dividends are a visible, tax-preferred return on investment and a “set and forget” means of replenishing spending accounts. Investors may also interpret a stable or growing payout as a sign of management’s confidence in their ability to generate cash flow.

Many income-oriented asset classes have seen spectacular boom and bust cycles already play out. Witness the price of energy MLPs, which dropped in half over a span of 15 months after years of outperformance through early 2014. Today’s crowded dividend trade is different, and thankfully the end game is likely to be far less ruinous.

The most obvious point of contrast is the broad cross-section of industries from which the currently popular dividend-payers hail (examples: J&J, Pepsi, P&G, Microsoft). Low interest rates are encouraging corporations to issue debt and simultaneously raise their dividends and/or repurchase their shares. Activist shareholders have added to the clamor for more. In the first half of 2016, companies in the S&P 500 paid out over 100% of their earnings in dividends or share buybacks. While energy stocks topped the list, other sectors including consumer staples, information technology and industrials have reached their highest dividend payout ratios in at least five years. Even in the best of times, the growth of these remittances is likely to slow and in some cases they could be cut outright. Any weakening in the economy would hasten such a recalibration, disappointing investors along the way.

There are other risks to consider. An upward movement in long-term rates could render dividend stocks less competitive as sources of yield. Even a whiff of a possible change to the tax code eliminating the preferential tax treatment of qualified dividends (unlikely in our view) could rattle the group.

Ultimately, it is the underlying business and the valuation placed on it that determines investment risk, rather than the level of dividend. There is a price where an investment in even the safest business doesn’t make sense. The current valuation disparity between the favored and the rest will be resolved over time, and it may grow wider before it narrows. Until then, resisting the urge to jump onto crowded bandwagons should be a key part of any strategy to manage risk and return.